THE OPTIONS COURSE- Tools of the Trade
THE OPTIONS COURSE
Tools of the Trade
Options traders today have a wide array of tools at their disposal. Thanks to the Internet and the proliferation of finance-related web sites, a great deal of information is available at no cost at all. In addition, many online brokerage firms today provide a large amount of research, information, and analytical tools to their customers. However, the abundance of tools and information can also be a double-edged sword when traders get bogged down by information overload and subsequently lose sight of the real objective of options trading—making profits.
We examine some of the tools traders use. Not all of them are necessary. Some, like stock charts, may seem essential; but a number of successful traders can even get by without those. So, when reading through this chapter, and learning about some of the featured tools of the trade, keep in mind that not all of them are absolutely necessary. Instead, think of them as shortcuts that are designed to make your trading life a great deal easier.
WHAT YOU REALLY NEED TO KNOW
Successful options trading requires a certain level of knowledge that is generally not taught in schools or universities. Options traders should know the basics of the stock market like understanding stock symbols, quotes, placing orders, and the factors that cause prices to rise and fall. In addition, traders should also understand options basics like the difference between puts and calls, the relationship between the strike price of an option and the price of the underlying asset, the impact of time decay, expiration dates, and the difference between opening and closing transactions. In short, trading options requires a basic understanding of how the stock and options markets function.
A visit to the local library will produce hundreds of books on the stock market and options trading. Watching financial television such as CNBC during the day and the Nightly Business Report in the evening can help you get a better understanding of the financial markets. Doing a search on the Internet will yield thousands of free articles that cover the markets and trading strategies. Optionetics offers free trading education, brokerage reviews, articles, commentary, and market data information. Once a certain foundation of trading knowledge has been attained, and an individual wants to begin trading, most brokerage firms will provide the required tools including the ability to place orders, assistance from a broker, and price quotes.
So since learning the essentials of options trading can be done for a small cost, it is possible to become a successful options trader through self-learning. While much of the information and tools required to successfully trade options is widely available at no cost, some products and services can increase the odds of success by making life easier. For example, attending a seminar can save an enormous amount of studying time by providing a structured set of courses of proven strategies. In addition, students can ask their instructors questions directly before, during, and after the seminars. Technology and the Internet have also helped immensely. When I started teaching options trading strategies more than 10 years ago, most traders relied on magazines and newspapers to make trading decisions.
So since learning the essentials of options trading can be done for a small cost, it is possible to become a successful options trader through self-learning. While much of the information and tools required to successfully trade options is widely available at no cost, some products and services can increase the odds of success by making life easier. For example, attending a seminar can save an enormous amount of studying time by providing a structured set of courses of proven strategies. In addition, students can ask their instructors questions directly before, during, and after the seminars. Technology and the Internet have also helped immensely. When I started teaching options trading strategies more than 10 years ago, most traders relied on magazines and newspapers to make trading decisions.
More experienced traders knew how to use options pricing models, the Internet, and charting software, but the process of finding trades and creating risk graphs was extremely costly and time consuming. Today, a number of software programs greatly simplify the process of creating hypothetical trades, viewing variables (such as implied volatility, delta, and theta), and creating risk graphs. Again, using computer software is not essential to trading success, but it greatly simplifies the decision-making process—especially as traders become more experienced and develop a greater need for more sophisticated information. In order to determine what type of information they need, we encourage new students to focus on one or two strategies and paper trade them until they feel comfortable enough to create trades with real money on the line.
The initial first step should be to develop a basic understanding of the market and options trading. The fact that you have made it this far in this book indicates that you are, or already have, accomplished the first step. From there, new students can begin creating hypothetical trades on paper using one or two strategies. In the beginning, the goal should be to master a small number of strategies. Don’t try to become a “jack-of-all-trades” too quickly. Too many products and too many strategies in the early stages of this process can prove to be a distraction rather than an aid. Stock options trading in the United States began in the early 1970s. Obviously, many of the tools and services that exist today were not available to those early traders.
So, if you are not sure what type of information you need, put yourself in their shoes for a few months. Rely almost exclusively on the resources available in your local library like Value Line Investment Survey, The Wall Street Journal, and Investor’s Business Daily. Do the math by hand and paper trade one or two strategies. Doing so will help you better understand the calculations and get a better feel for how option prices change on a daily basis. From that point, you can use an online portfolio service to track your paper trades. Paper trading will help you to understand which tools, products, and services you might need to foster consistent options trading success.
CHARTS
Technical traders rely heavily on charts and indicators. In today’s market, most of this is done with computers and trading software. We will examine some of the software programs available to traders. For now, let’s examine the three most commonly used chart types: the line chart, the open-high-low-close (OHLC), and Japanese candlesticks. The simplest type of chart is the line chart. This type of chart is plotted using only closing prices over a period of time. On the vertical axis, we have the underlying asset’s price. The horizontal axis plots the time used—daily, weekly, monthly or annually.
When the graph moves higher, it tells us that the bank index, which is an index consisting of 24 banks, is increasing in price. When the chart moves lower, the BKW is losing value. Simple enough. The open-high-low-close (OHLC) is the one I use most often and is a common way of viewing the performance of a stock, index, or futures chart. Also known as the range bar chart, the graph provides the technical analyst with a great deal more information than the line chart because it includes more than just the closing price. It is constructed using the high of the day and the low of the day, along with the closing price.
FIGURE Line Chart
In a healthy advance, the bulls are firmly in control and driving prices higher. As evidence, the technical analyst wants to see the stock closing near the highs of the day. This is easy to do with an OHLC chart. Recall that the right horizontal on each OHLC bar represents the closing price. When these closing lines appear near the top of each vertical bar on the chart, it suggests that the bulls have the stock in control. However, when the bears seize a stock, the chartist is looking to see if the stock is closing near the low price of the day. For example, on the MSFT chart, during the decline in mid-October, the stock was finishing most trading sessions near the lows of the day, which was a sign that bears were firmly in control of MSFT during that time.
FIGURE High-Low-Close Bar Chart
If the market closed above the opening price, the body is often colored green or left blank (white). If the price closes below the opening price, the body is colored black or red. The colors will vary from one charting software package to the next, but green and red seem to be the most common. This color-coding of the body makes it easy to immediately see if the market closed above or below the opening price for the given time period. An OHLC bar gives you the same information, but the color-coding of the candlestick bar can be a bit more convenient.
CHARTS, VOLUME, AND VOLATILITY
A visual look at a chart can also give important information regarding a stock’s volatility and, for that reason, it is extremely important to option traders. Since the length of each bar in an OHLC chart is determined by the high and low prices of the day, short bars suggest that the stock is exhibiting low volatility. In that case, the trading ranges between the daily high and low prices are small. On the other hand, when the bars are longer, it means that there is a bigger difference between the highs and lows of the day. Therefore, longer bars suggest greater volatility. Most charts will also plot volume underneath the price area. Volume refers to the total activity in the underlying asset during the course of a day, week, month, and so on.
FIGURE Six-Month Candlestick Chart
For a stock, the volume refers to the number of shares traded. To some traders, volume is the single most important indicator used in technical analysis. When a stock is rising and volume increases, it suggests that buyers are actively bidding the price higher and shorts are running for cover. Strong volume during an advance is considered a bullish sign. On the other hand, when volume swells during a decline, bears are driving prices lower, bulls are in pain, and the action of the stock is considered poor. Therefore, studying volume gives the analyst a better sense of whether the bulls or bears are in control of the stock.
Volume is the total number of shares associated with a specific stock or market. Also known as turnover, it reflects the number of shares bought or sold relative to a specific security. For instance, if you purchase 100 shares of Microsoft, the volume of that trade is equal to 100. Volume is considered during daily time periods. For instance, on Wednesday, February 18, 2004, total volume on the Nasdaq Stock Market equaled 1,777,995,664 shares. Therefore, daily volume is generally defined as the number of shares traded in one day and can be considered for one individual stock, an options contract, or an entire market. Tall bars suggest heavy volume while short bars indicate periods of low trading volume.
COMPUTER SOFTWARE
When I started trading, the charts we had available to us were newspapers or other print publications. Today, however, charting software makes the process extremely fast and easy. While there are a large number of great packages out there, we will just mention the three that our students seem to use most often: Once inside the site, traders can perform a host of options related studies including creating hypothetical trades, plotting volatility charts, back-testing strategies, viewing historical prices and implied volatility levels, monitoring put/call ratios, initiating trade searches based on specific parameters, and plotting risk graphs.
ProfitSource is a market analysis program that combines a fully featured technical analysis suite with a comprehensive set of special market direction tools such as Elliott wave, trend filters, and gap filters. These tools enable the user to adopt a rule-oriented approach to trading. In addition, it has the ability to scan for potentially profitable opportunities such as Wave 4 and Wave 5 trades, a state-of-the-art “Walk Through Mode” for learning how to apply concepts such as Elliott wave, alerts functionality for price, indicator and Elliott wave parameters, and a complete portfolio management package.
ProfitSource can be used in multiple markets including stocks, indexes, futures, and foreign exchange and gives the user access to international markets. Advanced GET from eSignal has also gained popularity among options traders. It is a graphical charting package that gives traders access to a full set of technical analysis tools, specialty tools and indicators based on Elliott waves and Gann theory, and also one of the most complete sets of standard studies available in the market today. Many options traders use these three software packages to enhance their ability to confidently use options strategies.
ProfitSource can be used in multiple markets including stocks, indexes, futures, and foreign exchange and gives the user access to international markets. Advanced GET from eSignal has also gained popularity among options traders. It is a graphical charting package that gives traders access to a full set of technical analysis tools, specialty tools and indicators based on Elliott waves and Gann theory, and also one of the most complete sets of standard studies available in the market today. Many options traders use these three software packages to enhance their ability to confidently use options strategies.
PUTTING IT ALL TOGETHER
In order to get a better understanding of how traders combine trading tools to create a promising trade, let’s work through a simple example. The first thing we need to employ is a method of finding stocks that are expected to make a strong directional move to the upside or the downside. In this case, we are looking for an explosive move higher. There are several tools on Platinum that help us find stocks, but for this example we will use the Candlestick I tool. This tool searches for stocks based on candlestick formations. In this case, we chose the Bullish Patterns search using stocks that were trading above $12.50 and that had volume above 300,000.
Once a list of stocks appears, we need to look at various price charts and implied volatilities. To keep things simple, suppose we find a bullish stock and decide to buy a long call. When buying a call, we want the implied volatility to be below the average IV for at least six months. Remember, when IV is low, the options are cheaper. After eyeballing the charts, we found that Lehman Brothers (LEH) looked like a strong candidate. Not only did the stock form a bullish pattern known as a Harami, but it also bounced off support at its ascending trend line. Once we find a stock that looks promising, we want to check IV to make sure it isn’t too high.
We can see by looking at this chart that IV was definitely low on a historic basis. This is important because the higher the IV, the more the option will cost. IV also acts like elastic, stretching to extremes, but ultimately coming back to its mean. If we buy a call and IV increases, it raises the price of the option. Now that we have a stock picked out that fits our criteria, we can enter the data into Platinum to view the risk graph. Before we actually enter the data into the Create Trade screen, we need to first decide which option strike and expiration month we want to test. Of course, after this is entered into the graph, we can view it to see if the trade makes sense given our outlook and resources.
Since we are buying an option, we want to give the trade enough time to work in our favor. Mainly, we don’t want to hold long options that expire in less than 30 days because time erosion picks up the last month of an option’s life. The stock closed the session at $66.04 and since we don’t normally want to use too far out-of-the-money options, let’s look at the October 70 call. We choose the October expiry month because June and July are too close and there aren’t any August or September options on May 20 to choose from.
FIGURE Daily Chart of LEH
FIGURE IV Chart for LEH
FIGURE IV Chart for LEH
This screen is just part of what Platinum tells us about the trade, but there is plenty to see from just this information. First, we see that the model price is between our bid-ask spread, so we know that option isn’t overpriced. Second, we can see our breakeven point at expiration. It is important to remember that the breakeven point here is figured as of expiration. Usually, we will see a profit well before this point. This screen also gives us the Greeks and the specific option information.
FIGURE Trade Data for LEH Call
This graph gives us a visual of what the profit or loss would be given a move in the stock and using different time frames. Obviously, if the stock moves up in the short term, we will see higher profits than if it takes three months to occur. Our initial debit was $340 in this trade for buying one long October 70 call. By looking at the chart, we can see that the stock would need to move to approximately $72 for our call option to double in price. Another tool we can use to assess the trade is the implied volatility chart. We can see that a rise in IV can affect the trade drastically, and that is why we want IV in our favor.
Before we enter the trade, we should have already decided on our exit points. The price we decide to sell at should be based on our outlook and money management. Remember that it’s always important to have a set exit point before entering a trade to take the emotion out of it. An oft-used exit strategy for a long call is to sell if the option loses half its value to the downside or when the option doubles in price to the upside. Of course, we can always set stops once our price target is achieved to let our profits run, but the last thing we want to do is see a profitable trade turn into a loser.
FIGURE IV Chart for LEH Trade
This trade did indeed work out well, with LEH shares moving up following this bullish sign. As originally expected, the stock went higher and our option was at a double on June 2 with the stock trading near $72.50. At this point, either the option could be closed or the trader could set a stop to make sure that if the stock were to move lower, the option would be sold before the profits were lost. Keep in mind that buying long calls is a great way to use leverage, but it is also a high-risk one. When the strategist identifies an explosive situation like in the Lehman Brothers example, he or she might want to consider other trades like bull call spreads, call ratio backspreads, or some of the other bullish strategies.
CONCLUSION
Not all traders use charts or computers. In fact, 20 years ago much of this information was either not available or extremely expensive. So, traders do not need to spend a lot of money on research and analytical tools. A high-speed Internet connection, a brokerage firm that specializes in options trading, and access to research can produce enough information to trade successfully.
Hopefully, this has helped to expand your knowledge regarding the tools that are available and how a trader uses information to create a trade. The example toward the end of the chapter explained how to find an explosive opportunity and how to analyze the situation to find the best options contract for the given strategy. Not all successful traders use the same approach. Through time, you will undoubtedly develop your own tools and methods for picking winning trades.
